You can learn a lot from the disclosure of the company’s board of directors in the annual report, but it takes time and knowledge to understand the clues of the quality of corporate governance, which is reflected in the composition and responsibilities of the board of directors.
In theory, the board of directors is responsible to shareholders and should manage the company’s management. But in many cases, the board has become the servant of the chief executive officer (CEO), who is usually also the chairman of the board.
In view of the scandals of companies such as Enron, WorldCom, and Southern Healthcare, the role of the board of directors is increasingly under scrutiny. In these scandals, directors have failed to act in the best interests of investors. Although the Sarbanes-Oxley Act of 2002 made companies more accountable, investors should still pay attention to the responsibilities of the company’s board of directors. Here, we will show you what the board of directors can tell you about the company’s operations.
- Look at the size of the board and see if it has enough members to function normally, including avoiding conflicts of interest, or if it is too cumbersome and therefore less efficient.
- See if the board includes independent outsiders—experienced business leaders who have no direct contact with the company, such as retired former employees or relatives of current executives.
- Consider the structure and effectiveness of the four most important board committees—the executive committee, audit committee, compensation committee, and nomination committee.
- Understand the time limits and other responsibilities of board members outside the board, and determine whether these other commitments are inherently problematic.
- Finally, look at any transactions between the company and executives and directors to see if anything raises any red flags by implying conflicts of interest or other issues.
The following questionnaire contains five key questions to help investors assess the objectivity and effectiveness of the company’s board of directors
1. What is the size of the board of directors?
There is no universal consensus on the optimal size of the board. Large numbers of members are a challenge in using them effectively and/or engaging in any meaningful personal participation.
Governance Today recommends 8 to 10 members as the optimal number. 8 people are more suitable for larger and more commercial operations, and 10 people are more suitable for small organizations.
According to a study Wall Street Journal, The smallest board size has an average of 9.5 directors. A large board of directors is defined as a board of directors with 14 or more board directors. Overall, the company has an average of 11.2 board directors.
In addition, two important board committees must be composed of independent members:
- Compensation Committee
- The Audit Committee
The minimum number of people on each committee is three. This means that at least six board members are required so that no one joins multiple committees. Allowing members to assume dual responsibilities may destroy the important barrier between audit and compensation, which helps to avoid any conflicts of interest. Members who serve on several other boards may not devote enough time to their duties.
The seventh member is the chairman of the board of directors. The chairman is responsible for ensuring the normal operation of the board of directors, and that the chief executive officer performs his duties and abides by the instructions of the board of directors. If the CEO concurrently serves as the chairman of the board of directors, there will be conflicts of interest.
To staff any additional committees, such as nomination or governance, additional staff may be required. However, more than nine members may make the board too large to function effectively.
Understanding the structure of the company’s board of directors can better understand the company’s overall situation, strengths and weaknesses, and how the company operates.
2. How many independent outsiders are there?
A key attribute of an effective board is that it is composed of most independent outsiders. Although not necessarily correct, a board with a majority of insiders is usually seen as a bunch of flatterers, especially when the CEO is also the chairman of the board.
External personnel are people who have never worked in the company, have nothing to do with any key employees, and have never worked for the company’s main suppliers, customers or service providers, such as lawyers, accountants, consultants, investment bankers, etc. Although the definition of independent outsider is clear, you will be surprised how often it has been misused. In many cases, when a retired CEO or relative is an insider with a conflict of interest, he will be labelled as an “outlier.”
according to Economic Times, The board of directors should strike a good balance between executive directors and non-executive directors (ideally, 50% each). If the chairman of the board is a non-executive director, at least one third of the board of directors should be composed of independent directors. On the other hand, if the chairman is an executive director, independent directors should account for at least half of the board of directors.
Generally speaking, the more members of the external board of directors, the better. This makes the board more independent and enables it to provide shareholders with a higher level of corporate governance, especially if the position of chairman of the board is separated from the CEO and held by outsiders.
3. How is the board committee composed?
There are four important board committees: the executive committee, the audit committee, the remuneration committee, and the nomination committee. Depending on the corporate philosophy, there may be more committees, which are determined by the ethics committee and special circumstances related to a particular company’s business line. Let’s take a closer look at the four main committees:
- The executive committee consists of a small number of board members that are easy to reach and convene to decide on board deliberation matters that must be decided quickly, such as quarterly meetings. The procedures of the executive committee are always reported to and reviewed by the entire board of directors. Like a full board, investors should prefer independent directors to have a majority on the executive committee.
- The audit committee works with the auditor to ensure that the accounting books are correct and that there is no conflict of interest between the auditor and other consulting companies hired by the company. Ideally, the chairman of the audit committee is a certified public accountant (CPA). Usually, the CPA is not on the audit committee, let alone on the board of directors. The New York Stock Exchange (NYSE) requires the audit committee to include a financial expert, but this qualification is usually met by a retired banker, even if the person’s ability to detect fraud may be questionable. The audit committee should meet at least four times a year to review the most recent audit. If other issues need to be resolved, additional meetings should be held.
- Compensation Committee Responsible for setting the salary of senior management. Obviously CEOs or other people with conflicts of interest should not join this committee, but you will be surprised at the number of companies that allow this. Due to potential conflicts of interest, it is important to check whether the members of the compensation committee are also on the compensation committees of other companies. The compensation committee shall meet at least twice a year. Only one meeting may indicate that the committee is meeting to approve the compensation package created by the CEO or consultant without much debate.
- Nomination Committee Responsible for nominating members of the board of directors. The nomination process should aim to develop people with independence and skills that the board currently lacks.
4. What other commitments and time limits do board members have?
When judging the effectiveness of members, the number of boards and committees on which board members are members is a key consideration.
Research shows that directors spend an average of more than 200 hours per year on board-related matters (equivalent to a full month’s workday).
You will often find independent board members serving on audit committees and compensation committees, and also serving on three or more other boards. You must want to know how much time a board member can devote to the company’s business if that person is on multiple boards. This situation has also raised questions about the supply of independent outside directors. Do these people assume dual responsibilities because of the lack of qualified outsiders?
5. Are there related transactions that may cause conflicts of interest?
The company must disclose any transactions with executives and directors in a financial report called “Related Transactions.” This reveals behaviors or relationships that lead to conflicts of interest, such as doing business with a director’s company or asking relatives of the CEO to collect professional fees from the company.
The composition and performance of the board of directors illustrate to a large extent its responsibilities to the company’s shareholders. If the major deficiencies in this list damage its objectivity and independence, the board of directors will lose credibility. Substandard governance practices cannot serve investors well.